The current political discussion about the merits of the draft Brexit withdrawal agreement is focusing on a provision that may never take effect. The backstop in respect of the Irish border is an insurance provision. It is an agreement between the parties on what the state of affairs should be in the event of something else not happening.That something is a full relationship agreement between an independent UK and the EU. This needs to be in place by the end of 2022 at the latest, as that is the last possible date the transition period can be extended to under the draft exit agreement. Only if there is no relationship agreement by then does the Irish backstop provision apply.So the controversy over whether the UK can accept such a provision is predicated on one simple assumption: that the UK and EU will not be ready to enter a relationship agreement by the end of the transition period under the exit agreement.If that is the case, then a no-deal Brexit is not avoided with the exit agreement but merely postponed. The famous “cliff-edge” would still very much be there, waiting for the UK to topple over in due course, just a little further along.The EU27, and Ireland in particular, are sensible in making this assumption. Nothing that has happened to date on Brexit provides any evidence, let alone comfort, that the parties will be in a position to sign a relationship agreement in the time available.If there is no relationship agreement by 2022, then all the horrors associated with a no-deal Brexit will simply re-emerge, from customs blockages to food and medicine shortages. The position of the Irish border, though of the upmost importance, will be one of many problems. And no sensible person believes the UK will be in a position to deal with these by 2022, just as it has signally failed to get ready over the past two years or so. So every expression of concern about the Irish backstop is an implicit admission that the UK is unlikely to have a relationship agreement to enter into by 2022 — indeed, it may not be ready for some years after that. Therefore, the supposed distinction between no-deal Brexit and the deal is to a large extent artificial: the real choice is between no deal now and no deal in 2022.If politicians were confident that a relationship deal would be in place by 2022, the backstop issue would lose a great deal of potency. But it appears they are in denial about the improbability of reaching a relationship agreement by 2022 and are instead focusing on the logical consequence of this, the backstop, almost as a form of proxy.One would hope, if not expect, that the likelihood or otherwise of there being such an agreement in place at the end of the transition period would be the basis on which Britain’s politicians were forming their views on the merits of the Brexits on offer. There not being such a deal likely to be ready by 2022 is a good reason for a responsible and rational politician, acting in the national interest, to seek a revocation of the Article 50 notification.But they are closing their eyes to this looming problem, just as they did with the consequences of making a premature and ill-prepared Article 50 notification. The EU27 are not so dumb as to make the same mistake; that is why they are protecting their interests and those of Ireland in the event of there being no relationship agreement. It is unfortunate that UK politicians are preoccupied only with the manifestation of this dreadful eventuality, rather than the eventuality itself.The writer is a contributing editor of the FT

Short-term US Treasury yields have climbed to match global bond markets’ average yield for the first time since the financial crisis, with analysts and fund managers warning that the increasing attraction of cash will be a headwind for financial markets in 2019. The yield of three-month Treasury bills — the financial system’s closest equivalent to cash — has climbed steadily since the Federal Reserve’s first interest rate increase in late 2015, to a nearly 11-year high of 2.42 per cent last week. Bond market yields have climbed since their mid-2016 lows, propelled by tighter US monetary policy and expectations that the global economic recovery was broadening and strengthening. However, the yield of the Bloomberg Barclays Multiverse Index — a broad $52tn benchmark of bonds issued by governments and countries around the world — dipped back to 2.41 per cent last week as investors became glummer on the growth outlook.The market behaviour highlights how 2018 has become an inflection point in the post-crisis regime, with the era of quantitative easing being replaced by “quantitative tightening” as the Fed shrinks its balance sheet and lifts rates. Add to that the European Central Bank’s effort to trim and, by the end of 2018, end its own QE programme. Treasury bills have already outperformed global stocks, bonds and commodities this year, an unusual occurrence that some analysts fret could happen again in 2019, as the monetary tide that lifted almost all boats since the financial crisis continues to recede. “A common theme in this cycle has been the hunt for yield, with investors moving into unfamiliar asset classes searching for higher returns to offset the low yields in core bonds,” JPMorgan Asset Management wrote in its annual outlook. “This isn’t necessarily an incorrect strategy in the early or middle stages of an economic expansion; however, in the late cycle this approach becomes riskier.” The danger is that the rising lustre of cash dims the allure of other asset classes. While there are currency aspects that mean that the broad, international Multiverse bond index is not directly comparable to short-term Treasuries — let alone equities — investors may be less willing to take on their additional risks when cash returns become more competitive.

While analyst opinions on the coming year differ significantly, most predict it will be even more challenging for financial markets, even as cash continues to do well.Morgan Stanley’s analysts think government bonds will eke out a 1 per cent gain in the coming year, while equities tread water, and corporate debt loses 5 per cent. However, they predict that cash will return 4 per cent.

Investors think an end to rate hikes is in sight, but the data the Federal Reserve cares about most are saying otherwise

By Justin Lahart

Federal Reserve Chairman Jerome Powell speaking at the Economic Club of New York on Nov. 28. Photo: carlo allegri/Reuters A nasty stock market tumble and some ill-chosen (or poorly interpreted) words from the head of the Federal Reserve suddenly have investors bracing for an economic slowdown and an end to interest-rate increases. The better approach is to watch the data, which have shown no sign of weakening.A month ago, investors expected the Fed to raise rates later this month and two or three times in 2019. Now, interest-rate futures suggest that one increase next year is the most likely outcome. The bond market, meanwhile, is suggesting the chances of a recession next year have risen.The way to get this right is to watch the job market, just like Fed Chairman Jerome Powell will do. Strong job growth raises the risk of inflation, which the Fed needs to prevent. The employment report this Friday, which economists expect will show the economy added about 200,000 jobs last month, could serve as an unwelcome reminder to investors that the Fed is unlikely to stop raising rates.But a real slowdown in employment won’t likely show up in the monthly jobs data right away.

To more quickly catch a shift, there are other more timely—though also more imperfect—reports to pay attention to. All are going strong right now.Chief among them is the Labor Department’s report every Thursday on initial claims for unemployment, says High Frequency Economics economist Jim O’Sullivan, since these often hook higher before weakness shows up in the monthly job report. But while claims have lately been higher than the nearly 50-year low they plumbed in September, they are still plenty low, suggesting the economy is generating enough jobs to keep the Fed tightening.Business surveys are another thing to watch, though these, too, continue to suggest the labor market is strong. The employment index in the Institute for Supply Management’s manufacturing report earlier this week suggested that job growth accelerated last month. Similarly, employment measures in household surveys, such as the University of Michigan’s sentiment index, could provide an early read on a downshift in the job market—and so far look healthy.Anecdotal reports on the job market, such as those contained in the Fed’s Beige Book, could also give investors a heads-up on whether the job market is cooling. But the latest Beige Book, released Wednesday, was rife with reports of companies struggling to attract and retain qualified workers, including in Chicago, where it reported several firms “said that they had been ‘ghosted,’ a situation in which a worker stops coming to work without notice and then is impossible to contact.”That’s the sort of story that could come back to haunt investors expecting the Fed to go on hold.

- The standard narrative is that bad banks full of bad bankers did bad things, causing the Great Recession (GR).- The alleged bad things, including terrible and terribly ubiquitous subprimes and a massive rise in leverage, make good scapegoats, but they did not, in fact, cause the GR.- The GR was caused by multiple equilibrium (ME) in the banking system. "It was the system, stupid" is the correct narrative.- Dodd-Frank did nothing to eliminate ME, i.e., the economy flipping from a good to a terrible state thanks to its unstable banking system.- There is a bulletproof solution that fixes banking for good by eliminating the bad equilibrium. It features 100 percent equity-financed mutual fund banking subject to government real-time supervised verification and full disclosure.

Some bad banking is a constant. But this time was different. Virtually all outstanding mortgages were subprime and virtually all subprimes were fraudulent no-doc, liar, and NINJA loans. Bank leverage reached record levels. Massively bribed rating companies gave triple As to securities that were triple Fs.

Regulators were totally outgunned, outnumbered, and out of touch. House prices soared, forming an incredible bubble. Derivatives became “weapons of mass destruction.”[1] Trading grew exponentially. And well-greased politicians looked the other way. The Financial Crisis Inquiry Commission (FCIC) summed it all up in two words – “pervasive permissiveness.”

There’s just one problem with this narrative. As argued here, it doesn’t fit the facts. Worse, it diverts attention from the real problem. The real problem wasn’t rampant misuse of a good banking system. It was regular use of a bad banking system – a banking system built to fail.

Structural failures have structural causes. The Hindenberg had a short circuit. The Challenger had faulty O-rings. The Titanic had unsealed bulkheads. The I-35 Mississippi Bridge had inadequate gusset plates. Our banking system had leverage and opacity. It failed colossally. It was bailed out, rebuilt to original spec, and is set to die another day.

The FCIC didn’t reference a single economic analysis of banking, let alone ME. There was no

mention of Keynes (1936), Bryant (1980), Diamond (1982), Diamond and Dybvig (1983), Shell (1989), Peck and Shell (2003), Bikhchandani, et. al. (1992), Cooper (1999), Chamley (2004), Goldstein and Pauzner (2005), Bebchuk and Goldstein (2011), or any other classic ME study that would have screamed SYSTEM, NOT OPERATORS! No surprise. The FCIC was built to miss and retain the forest. It had ten commissioners. Only one was an economist and he had no background in banking.

Pardoning The Usual Suspects

If the GR’s accused villains held smoking guns, everyone would know who shot the sheriff. They didn’t. Lo (2012), after reviewing 21 GR books, concluded that none agreed who had done it. Makes sense. The facts clear them all.

Subprimes

Subprime losses were too small to produce a recession, let alone a “Great” one. Indeed, during the GR, the subprime foreclosure rate peaked at only 15 percent.[2] Since at most, only 14 percent of outstanding mortgages during the GR were subprime, at most, only 2.1 (.15 x .14) percent of all mortgages during the GR represented foreclosed subprimes.

Furthermore, if subprimes were terrible assets, the Fed’s $29 billion purchase of Bear Stearns’ worst subprimes – a clear overpayment to bribe JP Morgan to buy Bear - would have produced a major loss. Despite the subsequent GR, these worst-of-class subprimes didn’t lose a penny. Indeed, the investment repaid $31.5 billion.[3]

The Housing Price Bubble

The FCIC included “an unsustainable rise in housing prices” in its top-7 GR causes. Prior to 2007, real house prices rose steadily for 32 years. The rise was slow – 64 percent compared to 170 percent for real GDP. Yes, roughly a third of this increase occurred from 2003-2007. But, during this period, real house prices rose by only 2 percentage points more per year than did real GDP. One can construct models with real housing prices staying fixed and the quantity of houses rising, or the opposite.

Given the increasing urbanization of the country, the fixed supply of central city land, and the remarkable foreign demand for U.S. housing,[4] an irrational bubble isn’t needed to explain the pre-GR real price rise. Indeed, the FCIC’s “housing-price bubble” could be called “normal increases following years of abnormally low increases.” Moreover, housing-price changes simply redistribute between sellers and buyers, but have no impact on the economy’s real wealth. Hence, the alleged bursting of “the housing price bubble” did not constitute a real shock to the economy.

Ratings Shopping

The FCIC’s report states that failures of the big-three rating companies were "key enablers of the financial meltdown." But Benmelech and Dlugosz (2010), who studied the rating of 180,000 CDO tranches, concluded, “It is not clear that rating shopping led to the ratings collapse as the majority of the tranches in our sample are rated by two or three agencies.”[5] Since structured-finance securities represented only 35 percent of the U.S. bond market in 2008, since only 7 percent of these securities were re-rated, and since, at most, 20 percent were over-rated due to ratings shopping, overrating affected less than one half of one percent of the U.S. bond market.

In addition, this figure overstates the importance of ratings shopping as the downgrades were caused by the GR. i.e., why re-rate and lose the next bribe unless you’re forced to by the market?

Bank Leverage

A stable fable regarding the run up to the GR is that banks dramatically increased their leverage. Not so. Fed data show bank leverage falling from 1988 through 2008.[6] Equity rose from 6 percent of bank assets in Q1 1988 to 10 percent in Q1 2008. Leverage was also not particularly high in either Bear Stearns or Lehman.[7]

According to Christopher Cox, former Chair of the Securities and Exchange Commission, Bear Stearns was well capitalized when it failed, with a capital ratio over 13 percent and a debt-equity ratio of 6 to 1.[8] Cox stated,

The fate of Bear Stearns was the result of a lack of confidence, not a lack of capital. … at all times until its agreement to be acquired by JP Morgan Chase …, the firm had a capital cushion well above what is required to meet supervisory standards… .[9]

In the event, Bear’s actual capital ratio didn’t matter. ME mattered. Creditors, past and prospective, came to believe, based on innocent and guilty rumors, that other creditors were pulling the plug.

Lehman was also well capitalized prior to its demise. It had tier-1 capital of 11 percent when its creditors pulled the plug.[10] An 11 percent capital ratio is close to the current banking system’s tier-1 capital ratio of 12.3 percent according to the Fed’s recent stress tests. Thus, today’s banking system is no safer than the day Lehman was driven out of business.[11]

Mortgage Debt

Another GR “smoking gun” is the pre-GR run up of mortgage debt, which roughly doubled between 2002 and 2007.[12] But the increase in borrowing to purchase homes wasn’t associated with a rise in household consumption relative to GDP. Instead, Americans borrowed to invest. And although the ratio of mortgage debt to household net wealth rose, the rise was minor. So too was the rise in debt payments relative to personal income.[13]

Derivatives

The reigning narrative – that derivatives were overrated, complex securities sold to naïve investors doesn’t jive with Ospinal and Uhlig (2018).[14] They examined 8,615, 2007-2013 residential mortgage-backed securities (RMBS), almost all of which were rated AAA. Three quarters of the AAA-rated RMBS had essentially zero losses through 2013. On a principal-weighted basis, the average loss rate was only 0.42 percent. Most striking, AAA-rated RMBS outperformed the universe of AAA-rated securities.

Fahlenbrach and Stulz (2011) examined pre-GR executive compensation contracts of 95 banks. The stock and option compensation in these contracts exceeded wages by a factor of eight.[17] The authors also state,

Banks with higher option (and bonus) compensation … for their CEOs did not perform worse during the crisis. Bank CEOs did not reduce their holdings of shares in anticipation of the crisis or during the crisis. Consequently, they suffered extremely large wealth losses in the wake of the crisis.

Jimmy Cayne, Bear’s CEO, is an example. He lost $1 billion. In short, bankers had plenty of skin in the game.

Regulatory Capture

The main job of bank regulators is overseeing bank leverage. Since bank leverage was not historically high, indeed fell in the advent of the GR, regulators did their job. What they couldn’t do was prevent our unstable economy from switching equilibriums.

Democratization of Finance

Politicians, some say, forced Fanny and Freddie to support too much risk for the poor. But for this to be a major cause of the GR, losses from subprime mortgage foreclosures would need to have been much larger.

Fed Interest Rate Policy

In the 1990s, the expected real 30-year mortgage rate averaged 7.91 percent. It averaged 6.27 between January 2000 and December 2007.[18] This decline is too small to matter.

Furthermore, the Fed doesn’t directly control long-term nominal, let alone real mortgagerates.As for adjustable rate 5/1-year adjustable rate mortgages (ARMs), its real rate averaged between 5 and 6 percent in the two years preceding the GR. Real rates of this magnitude are not low.[19]

Unsafe At Any Speed

Bank failures have a special midwife – opacity. Opacity permits misinformation to spread and be spread. Bear was among the first to be picked off by short sellers because it was viewed as particularly opaque. According to Cohan (2010), no one on the street or inside the bank, really knew what its assets were worth. The fact that Bear’s stock was valued at $60 per share one week before it was sold for $2 per share says that its asset valuation was a matter of pure conjecture. Apparently, before it didn’t, the market thought Bear’s assets were worth something because everyone else thought its assets were worth something. Such self-fulfilling prophecies is the stuff of ME.

Lehman’s CEO, Richard Fuld, publicly testified, “… what happened to Lehman Brothers could have happened to any financial institution.”[20] The facts support his view. Bankers didn’t destroy the banking system. The banking system destroyed the banking system. It operated in the dark and it operated with leverage. That, plus rumors of rampant malfeasance, brought the entire house of cards tumbling down.

The takeaway is that banking can’t be fixed with cosmetic reforms, such as the U.S. Dodd-Frank reform or the UK’s Vickers Commission Report.[21] What’s needed is a system with zero leverage and full, government-supervised disclosure. Why zero leverage and full disclosure? The answer is simple. You can’t be a little bit pregnant. Any degree of leverage and opacity invites ME.

Kotlikoff (2010) provides a very simple means, called Limited Purpose Banking (LPB), to fix banking for good. LPB would transform all financial corporations into 100 percent equity-financed mutual fund holding companies subject to full and real-time disclosure, affected by private firms working exclusively for the government.

Here is Fuld’s relevant testimony re its 11 to 1 Tier 1 capital. “As far as the leverage, and I spoke about it earlier, there's a very big difference between the 30 times and where we were when we finished in the third quarter at 10\1/2\. A big piece of what that 30 was, again, was the match book, which was governments and agencies. So that should not be considered as an additional piece of risky leverage.

Again, I will say that on September 10th we finished with the best or one of the best leverage ratios on the street and one of the best tier 1 capital ratios on the street. And, even to your question, that's how I viewed the company, and that's why I viewed it as strong, Mr. Congressman. Those were the metrics. Those were the metrics that the regulators used. Those were the metrics that all of us in the industry used, and ours were one of the best.”

What happens in this world is the result of what people choose to do and choose not to do when presented with challenges and opportunities. The 41st US president didn't always make the right choices, but his administration’s foreign policy record compares favorably with that of any other modern leader.

Richard N. Haass

CAMBRIDGE – I have worked for four US presidents, Democrats and Republicans alike, and perhaps the most important thing I have learned along the way is that little of what we call history is inevitable. What happens in this world is the result of what people choose to do and choose not to do when presented with challenges and opportunities.George H.W. Bush, the 41st president of the United States, was presented with more than his share of challenges and opportunities, and the record is clear: he left the country and the world considerably better off than he found them.I worked for and often with Bush for all four years of his presidency. I was the National Security Council member responsible for overseeing the development and execution of policy toward the Middle East, the Persian Gulf, and Afghanistan, India, and Pakistan. I was also brought into a good many other policy deliberations.Bush was kind, decent, fair, open-minded, considerate, lacking in prejudice, modest, principled, and loyal. He valued public service and saw himself as simply the latest in the long line of US presidents, another temporary occupant of the Oval Office and custodian of American democracy.His foreign policy achievements were many and significant, starting with the ending of the Cold War. To be sure, that it ended when it did had a great deal to do with four decades of concerted Western effort in every region of the world, the defeat of the Soviets in Afghanistan, the deep-seated flaws within the Soviet system, and the words and deeds of Mikhail Gorbachev. But none of this meant that the Cold War was preordained to end quickly or peacefully.It did, in part, because Bush was sensitive to Gorbachev’s and later Boris Yeltsin’s predicament and avoided making a difficult situation humiliating. He was careful not to gloat or to indulge in the rhetoric of triumphalism. He was widely criticized for this restraint, but he managed not to trigger just the sort of nationalist reaction that we are now seeing in Russia.He also got what he wanted. No one should confuse Bush’s caution with timidity. He overcame the reluctance, and at times objections, of many of his European counterparts and fostered Germany’s unification – and brought it about within NATO. This was statecraft at its finest.Bush’s other great foreign policy achievement was the Gulf War. He viewed Saddam Hussein’s invasion and conquest of Kuwait as a threat not just to the region’s critical oil supplies, but also to the emerging post-Cold War world. Bush feared that if this act of war went unanswered, it would encourage further mayhem.Days into the crisis, Bush declared that Saddam’s aggression would not stand. He then marshaled an unprecedented international coalition that backed sanctions and the threat of force, sent a half-million US troops halfway around the world to join hundreds of thousands from other countries, and, when diplomacy failed to bring about a complete and unconditional Iraqi withdrawal, liberated Kuwait in a matter of weeks with remarkably few US and coalition casualties. It was a textbook case of how multilateralism could work.Two other points are worth noting here. First, Congress was reluctant to act on Saddam’s aggression. The vote in the Senate authorizing military action nearly failed. Bush, however, was prepared to order what became Operation Desert Storm even without congressional approval, given that he already had international law and the United Nations Security Council on his side. He was that determined and that principled.Second, Bush refused to allow himself to get caught up in events. The mission was to liberate Kuwait, not Iraq. Fully aware of what happened some four decades earlier when the US and UN forces expanded their strategic objective in Korea and tried to unify the peninsula by force, Bush resisted pressures to expand the war’s aims. He worried about losing the trust of world leaders he had brought along and the loss of life that would likely result. He also wanted to keep Arab governments on his side to improve prospects for the Middle East peace effort that was to begin in Madrid less than a year later. Again, he was strong enough to stand up to the mood of the moment.None of this is to say that Bush always got it right. The end of the Gulf War was messy, as Saddam managed to hang onto power in Iraq with a brutal crackdown on Kurds in the north and Shi’a in the south. A year later, the Bush administration was slow to respond to violence in the Balkans. It might have done more to help Russia in its early post-Soviet days. Overall, however, the administration’s foreign policy record compares favorably with that of any other modern US president or, for that matter, any other contemporary world leader.One last thing. Bush assembled what was arguably the best national security team the US has ever had. Brent Scowcroft was the gold standard in national security advisers. James Baker was arguably the most successful secretary of state since Henry Kissinger. And with them were Colin Powell, Dick Cheney, Robert Gates, Larry Eagleburger, William Webster, and others of standing and experience.All of which brings us back to George H.W. Bush. He chose the people. He set the tone and the expectations. He listened. He insisted on a formal process. And he led.If, as the saying goes, a fish rots from the head, it also flourishes because of the head. The US flourished as a result of the many contributions of its 41st president. Many people around the world benefited as well. We owe him our collective thanks. May his well-deserved rest be peaceful.

Richard N. Haass, President of the Council on Foreign Relations, previously served as Director of Policy Planning for the US State Department (2001-2003), and was President George W. Bush's special envoy to Northern Ireland and Coordinator for the Future of Afghanistan. He is the author of A World in Disarray: American Foreign Policy and the Crisis of the Old Order.

If you know the other and know yourself, you need not fear the result of a hundred battles.

Sun Tzu

We are travelers on a cosmic journey, stardust, swirling and dancing in the eddies and whirlpools of infinity. Life is eternal. We have stopped for a moment to encounter each other, to meet, to love, to share.This is a precious moment. It is a little parenthesis in eternity.